forming a China WFOE

One of the most frustrating things about doing business in China is the paper work.

The seemingly endless paper work….

I was cc’ed on an email the other day from one of our China lawyers to one of our clients. The client had signed the documents required for a WFOE using the wrong ink. The ink the client used looked like the required ink, but it wasn’t. We told the client that the local Administration for Industry and Commerce (the “AIC” is where the WFOE filings go) would likely reject the application due to the wrong ink, but the client chose to go ahead anyway so as to potentially avoid having to go through the signing process again. This email (with all identifiers, including city) hidden, is to let our client know that the AIC did in fact refuse their application and setting out all that our client now needs to do to ensure acceptance the next time around.

To form a WFOE in China, you typically need around 25 documents, 33 originals, 594 signatures (18 times the 33 originals) and 297 seals (9 times the 33 originals). Fun stuff, let me tell you. I was quoted the other day in a New York Newsday article on China, in which a China consultant talked about how forming a China WFOE takes 6-12 months. The Wall Street Journal’s China Real Time Report, in a piece entitled, American Firms Find China Hard Work, noted the following from the recently released AmCham survey:

Investment approvals are particularly vexatious, with complaints ranging from apparently arbitrary decisions to excessive paperwork. The proportion of U.S. firms who think foreign and local companies compete on a level playing field with regard to approvals has fallen to 14% from 29% in 2011, according to the chamber’s survey.

The below email should give you a bit of flavor as to why forming a company in China can be so “vexatious.”
In line with our expectations, the _______ AIC rejected your WFOE application documents for having been signed with the wrong type of pen. Accordingly, please have the attached documents re-executed.

The instructions for signing follow:

1. AOA-Chinese: We need 5 Originals, all signed by ____________ and bearing the seal of ___________.

2. AOA-English: For reference only. No need to sign or return to me.

3. Application form-Chinese: We need 2 Originals, both signed by both _________ and _________ and bearing the seal of ___________.

4. Application form-English: For reference only. No need to sign or return to me.

5. Application Letter for Economic promotion bureau-Chinese: We need 2 Originals, both signed by __________ and bearing the seal of ___________.

6. Application letter for Economic promotion bureau-English: For reference only. No need to sign or return to me.

7. Application letter for stamp carving-Chinese: We need 1 Original, signed by ____________.

8. Application letter for stamp carving-English: For reference only. No need to sign or return to me.

9. Appointment letter (executive director and supervisor)-Chinese: We need 3 Originals, all signed by __________ and bearing the seal of ____________.

10. Appointment letter (executive director and supervisor)-English: For reference only. No need to sign or return to me.

11. Appointment letter (General manager)-Chinese: We need 3 Originals, signed by all of the board members (i.e., _________, _______________, and ______________).

12. Appointment letter (General manager)-English: For reference only. No need to sign or return to me.

15. FSR-Chinese: We need 3 Originals, all signed by _____________ and bearing the seal of __________.

16. FSR-English: For reference only. No need to sign or return to me.

17. Letter of authorization by legal person-Chinese: We need 2 Originals, both signed by ___________.

18. Letter of authorization by legal person-English: For reference only. No need to sign or return to me.

19. Letter of authorization for delivery of legal documents-Chinese: We need 3 Originals, all signed by ___________ and __________ and bearing the seal of ____________.

20. Letter of authorization for delivery of legal documents-English: For reference only. No need to sign or return to me.

21. Letter of undertaking to work safety-Chinese: We need 2 Originals, both signed by ___________ and bearing the seal of __________.

22. Letter of undertaking to work safety-English: For reference only. No need to sign or return to me.

23. The list of board members-Chinese: We need 3 Originals, all signed by _________ and bearing the seal of ___________.

24. The list of board members-English: For reference only. No need to sign or return to me.

25. Power of attorney: We need 3 Originals, all signed by _________ and bearing the seal of __________

IMPORTANT NOTES REGARDING SIGNATURES:

(1) The execution documents listed above have yellow “stickies” in the document indicating where to sign, and whose signature is required. When you print out these documents, make sure you do not print out these notes as well.

(2) Make sure to use A4 paper to print the documents and that your printer is set to A4. Note the number of pages and formatting of the documents to ensure that the formatting is consistent. If you have problems printing the documents, we can mail them to you. If you do not use A4 paper and the proper formatting, the documents will be rejected.

(3) All signatures must be made with a fine point rollerball pen using water-based ink, such as a Uniball, or a fountain pen. Do not use a thick ballpoint pen or a pen with oil-based ink. Sign in BLACK INK ONLY. All signatures must match the signature in the respective person’s passport.

(4) On those documents where the company seal (of __________) is requested, the seal should be affixed over the signature.

Once all of the above documents have been signed, please scan and email a copy to me, and send the physical documents directly to our China company formation agent.

Very helpful post over at the always helpful International Business Law Advisor Blog. The post is appropriately entitled, The 5 Key Factors You Must Consider When Establishing a Foreign Corporation [link no longer exists] and it lists out the following:

Decide on Corporate Form: The post talks of determining the right corporate form for the country in which you will be establishing your company. For China, this might mean Joint Venture, Representative Office, Wholly Foreign Owned Entity (WFOE), etc. For more on forming a company in China, check out the following:

Identify Your Business Purpose: The post notes how “unlike in the U.S., the business purpose of an entity in a great number of foreign jurisdictions require that the business purpose of the entity to be described in detail.” This too is true of China, where what you list as the scope of the business can end up limiting what it can do. For more on this, check out the following:

Choose the Corporate Name: The post notes how a “great majority of foreign countries have specific requirements regarding corporate names” and this is true of China as well.

Determine the Officer and Director, if any: The post notes how some countries do not recognize the U.S. concept of “director and officer” and of how residency requirements may also apply. China definitely has a different leadership structure than is familiar to Americans and this oftentimes results in problems.

Quantify Capital Requirements: The post notes how minimum capital requirements “necessary to form an entity varies by country.” This is actually true within China where some cities have fairly low minimum capital requirements and others have much higher such requirements. For more on China’s minimum capital requirements, check out the following:

Okay, so what is the missing, most important consideration of all? Whether it even makes sense to form a company overseas. This is by far the most important and also most complicated in forming an overseas entity.

Is forming a company overseas really the best way to accomplish what you are seeking to accomplish? Might you be able to sell your product or services pretty much as well via a licensing, franchising, or distributorship relationship? Do you really need a company in a foreign country to have your products made there or your research conducted there, or might you be better off just outsourcing?

Most importantly, is going overseas really right for your company. Running a single domestic company is tough enough. Now consider running two or more companies at the same time, with one or more of them being in a foreign country. Or as my friend Ben Shobert would say, Are You China Ready?

My law firm does a considerable business in forming China WFOEs. Unlike forming a company in the United States, which costs very little in out of pocket costs (always less than USD$1000) and takes almost no time at all (a few days at most), forming a company in China can be a long and expensive process. We typically start the procedure by sending out an email with the following LONG list of questions and document requests

Legal Name and Structure. Full legal name, legal structure (corporation, LLC, partnership), state of formation, and registered legal address of the shareholder of the WFOE. I assume that your U.S. entity will be the shareholder. If this is not correct, please explain.

Company Registration Document. Most recent registration document (usually called an annual report) from the state of formation showing the name, address and officers and directors of the shareholder. Our office can obtain this document after we receive your response to item 1 above.

Proof of Shareholder Existence. For this we will need certified copies of a) a certificate of good standing and b) the most recent annual report for the shareholder. These documents must be authenticated by the secretary of state of the state of formation and also must be authenticated by the applicable Chinese consulate or embassy. This is a complex process. Our office will handle obtaining these documents and processing with the relevant Chinese consulate/embassy.

Name of WFOE in Chinese and English. We can assist in selecting the name if you wish. Chinese company names are complex. For now, what we need is the basic name that you want. We will then work with the local authorities to determine what should be the full legal name. Note that China is really only concerned with the Chinese version of the name. There is no real control on the English name that you use.

Lease of Space for the WFOE. The lease must be valid for at least one year beyond the eventual approval date for the WFOE. Since approval may take some time, it is best to have the initial term of the lease be at least one-and-a-half to two years. The lease must be in proper format and must be registered with the local real estate authority. We will also need proof that the landlord owns the property in question and has the authority to enter into the lease. This is usually proved by provision of a land rights certificate and proof of existence of the landlord (National ID for an individual, business license for a company). We will work with you during the leasing phase to ensure the lease is properly executed and that the landlord has proper authority. Prior to your entering into the lease, we will determine whether the proposed use is permitted for the premises and whether the proposed address is acceptable for a WFOE. Leases are often the biggest obstacle for WFOEs, so this is a matter to address right away. Note also that the specific details of the documentation requirements for a WFOE depend on the district where the WFOE will be formed. We therefore need to know the proposed address for the WFOE or at least the proposed district before we can make a final determination of the exact procedures that will be required for WFOE formation. Note also that we cannot even begin the registration process in China until we know the address of the proposed registered office for the WFOE, as well as the proposed use. This highlights the importance of the lease in the registration process.

Scope of Business.We must specify the scope of business of the WFOE. Please provide a statement of what services the WFOE will perform on a daily basis. We need reasonable detail for this, but no more than one page. The scope of business should address the following questions, among others.

How many employees will be working there? Are they full-time or part-time? Will they be working in the leased space or off-site.

Will the number of employees vary over time?

What is the nationality of these employees?

What will each of these employees be doing in this rented space – will they be programming? consulting? buying? selling? manufacturing? providing customer support? managing other employees? something else?

Who are the customers of the business? That is, who will be paying for the goods or services provided by the WFOE?

What is the projected cash flow of the business? Where will income go (i.e., to the WFOE, to the parent, to an affiliated entity)? How will expenses be paid (i.e., directly by the WFOE, by the parent, by an affiliated entity, etc.)? Where will the WFOE get its money to operate?

The scope of business will also be used in the company name as noted in Question 4. above.

Feasability Study. We must provide a feasibility study that states the basic business plan of the WFOE. Our staff will draft that document. In order to do this, in addition to the information requested in Question 6 above, we need the following information:

Statement of start up expenses in reasonable detail.

One year and five year proforma income statement and balance sheet.

Statement of what services/product the WFOE will provide (to the extent not addressed in Question 6).

Statement of the expected cash flow of the WFOE: what entities will pay and what will they pay for (to the extent not addressed in Question 6)

Initial staffing plan for the WFOE with a three year and five year projection. Of particular importance is the nationality of the staff (to the extent not addressed in Question 6).

Statement of the business opportunity this WFOE will exploit, the expected market for the service, how you propose to meet the needs of that market and the benefit to China from the project.

Registered Capital. We must state the amount of the registered capital for the WFOE. This amount is the actual amount of capital that will be paid in by the shareholder as start-up capital for the WFOE. Registered capital is not a deposit: it is the actual operating capital used by the WFOE for payment of start up expenses such as rent, remodeling, equipment and salaries. There is no set number, since the amount required for each WFOE is different. As a rule of thumb, most Chinese regulatory authorities expect that registered capital will be equal to at least the first years expenses. Some districts have a minimum amount for registered capital. For example, districts in Shanghai generally require at least US $150,000 in registered capital. Note also that certain businesses will be required to have higher registered capital minimums. The rule is that all registered capital must be paid within two years after approval of formation of the WFOE. Fifteen percent of this amount, or the required minimum, whichever is greater, must be paid within 90 days after formation of the WFOE. The amount of registered capital must be considered carefully. Any amounts paid into the WFOE by the shareholder in excess of registered capital will be treated as income to the WFOE, and taxed as such. Accordingly, it is important not to set the registered capital number so low that you would encounter this problem. We will discuss this in more detail with you as we progress.

Management. WFOE can be managed through a) a board of directors or b) through a single managing director. For a board of directors, the number of directors is typically three. One director is selected as the representative director who has the right to enter into agreements on behalf of the WFOE. For the managing director, a single person is appointed as the managing director. This person is also the representative director. You will need to determine which management method you will use. For single shareholder WFOEs, the managing director approach is common. You will need to designate the following:

Directors.

If you will use a board, state how many directors. Provide the full name and address of each director.

If you will use a managing director, provide the full name and address of each director.

General manager.

The daily business of the WFOE will be managed by a general manager. This person can be a member of the board or an independent individual. The person can be a Chinese national or a foreign national. The person can be a resident of China or a non-resident. Typically, for a WFOE the general manager is a Chinese national who does not serve on the board and who is resident in China. However, there is no fixed pattern.

Supervisor.

The supervisor is responsible for supervising the conduct of the board in order to protect the rights of shareholders. In a one shareholder WFOE, the supervisor position is not necessary. However, Chinese law requires an appointment to this position. The person must be independent and cannot be a director or the general manager.

Documentation for each person.For each person above, provide the following:

Name and address.

ID: For non-Chinese citizens, we will need four color copies of their passport. For Chinese citizens, we will need four color copies of their national ID card.

Resume: one or two page, including birth information and address, signed, four originals.

Photos: four 2″ visa size photos.

Proof of financial status. Normally, this can be done through a letter from your bank stating the basics of your deposit relation with the bank. We will provide you with an approved form for this letter. In some cases, the Chinese authorities will require an audit of the investor company. We will determine as soon as possible whether such an audit will be required.

And the above is just for a typical WFOE. There are going to be all sorts of variations, depending on the type of WFOE being formed and even on the city or district in which it is being formed.

Everyone always wants to know how long forming a China WFOE will take and we always tell our WFOE formation clients (before they retain us) that it typically takes from 3-6 months and that our primary goal is always to work as quickly as we can, but that whenever we are faced with a situation where we have to choose between doing something 100% right and doing it fast, we always choose accuracy and precision over speed. If your WFOE is rejected once, the odds of it ever being accepted go way down.

Sometimes potential (and even existing) WFOE formation clients tell us of “someone” out there claiming to be able to form a WFOE in “just a couple of months.” To that, I always respond that every single reputable law firm (both Chinese and American and European) with whom I have spoken has told me that three months is their bottom line estimate for the time it takes to form a WFOE. I am bringing all of this up now because at the Doing Business in China seminar, two lawyers from two different highly reputable law firms put on their PowerPoints how long it takes to form a China WFOE. One put six months and the other put 4-6 months. These are the figures from start to finish and include the 30-90 days it can take once all documentation has been submitted to the appropriate authorities.

If anyone is assuring you that they can do a WFOE formation in “record time,” run, don’t walk away. Forming a WFOE in China takes time. Months of it.

Cheating a bit here, but since I am on the road, I cannot help it. I’m cheating because this post is nothing more than the typical email we send to our clients at the commencement of our work for them in forming a China WFOE. But I don’t feel bad because what better way to convey some of what it takes to get going with a China WFOE than by using a true to life example, freshly received today, no less. Here goes:

Following please find the preliminary information and documents that we will need for the WFOE formation. Depending on the exact nature of your activities in China and the requirements of the local government, we may need additional information at a later date. The below will be sufficient to get us started. Please never hesitate to contact any of us with any questions.

1. Full legal name, legal structure (corporation, LLC, partnership), state of formation, and registered legal address of the shareholder of the WFOE. I assume that your U.S. entity will be the shareholder. If this is not correct, please explain.

2. Most recent registration document (usually called an annual report) from the state of formation showing the name, address and officers and directors of the shareholder. Our office can obtain this document after we receive your response to item 1 above.

3. Proof of existence of the shareholder. For this we will need certified copies of a) a certificate of good standing and b) the most recent annual report for the shareholder. These documents must be authenticated by the secretary of state of the state of formation and also must be authenticated by the applicable Chinese consulate or embassy. This is a complex process. Our office will handle obtaining these documents and processing with the relevant Chinese consulate/embassy.

4. Name of the WFOE in Chinese and English. We can assist in selecting the name if you wish. Chinese company names are complex. For now, what we need is the basic name that you want. We will then work with the local authorities to determine what should be the full legal name. Note that China is really only concerned with the Chinese version of the name. There is no real control on the English name that you use.

5. Lease of office space for the WFOE. The lease must be valid for at least one year beyond the eventual approval date for the WFOE. Since approval may take some time, it is best to have the initial term of the lease be at least one-and-a-half to two years. The lease must be in proper format and must be registered with the local real estate authority. We will also need proof that the landlord owns the property in question and has the authority to enter into the lease. This is usually proved by provision of a land rights certificate and proof of existence of the landlord (National ID for an individual, business license for a company). We will work with you during the leasing phase to ensure the lease is properly executed and that the landlord has proper authority. Prior to your entering into the lease, we will determine whether the proposed use is permitted for the premises and whether the proposed address is acceptable for a WFOE. Leases are often the biggest obstacle for WFOEs, so this is a matter to address right away. Note also that the specific details of the documentation requirements for a WFOE depend on the district where the WFOE will be formed. We therefore need to know the proposed address for the WFOE or at least the proposed district before we can make a final determination of the exact procedures that will be required for WFOE formation. Note also that we cannot even begin the registration process in China until we know the address of the proposed registered office for the WFOE, as well as the proposed use. This highlights the importance of the lease in the registration process.

6. We must specify the scope of business of the WFOE. Please provide a statement of what services the WFOE will perform on a daily basis. We need reasonable detail for this, but no more than one page. The scope of business should address the following questions, among others:

How many employees will be working there? Are they full-time or part-time? Will they be working in the leased space or off-site?

Will the number of employees vary over time?

What is the nationality of these employees?

What will each of these employees be doing in this rented space – will they be programming? consulting? buying? selling? manufacturing? providing customer support? managing other employees? something else?

Who are the customers of the business? That is, who will be paying for the services provided by the WFOE?

What is the projected cash flow of the business? Where will income go (i.e., to the WFOE, to the parent, to an affiliated entity)? How will expenses be paid (i.e., directly by the WFOE, by the parent, by an affiliated entity, etc.)? Where will the WFOE get its money to operate?

The scope of business will also be used in the company name as noted in Question 4. above.

7. We must provide a feasibility study that states the basic business plan of the WFOE. Our staff will draft that document. In order to do this, in addition to the information requested in Question 6 above, we need the following information:

Statement of start up expenses in reasonable detail.

One year and five year proforma income statement and balance sheet.

Statement of what services/product the WFOE will provide (to the extent not addressed in Question 6).

Statement of the expected cash flow of the WFOE: what entities will pay and what will they pay for (to the extent not addressed in Question 6)

Initial staffing plan for the WFOE with a three year and five year projection. Of particular importance is the nationality of the staff (to the extent not addressed in Question 6).

Statement of the business opportunity this WFOE will exploit, the expected market for the service, how you propose to meet the needs of that market and the benefit to China from the project.

8. Registered Capital.

We must state the amount of the registered capital for the WFOE. This amount is the actual amount of capital that will be paid in by the shareholder as start-up capital for the WFOE. Registered capital is not a deposit: it is the actual operating capital used by the WFOE for payment of start up expenses such as rent, remodeling, equipment and salaries. There is no set number, since the amount required for each WFOE is different. As a rule of thumb, most Chinese regulatory authorities expect that registered capital will be equal to at least the first years expenses. Some districts have a minimum amount for registered capital. For example, districts in Shanghai generally require at least US $150,000 in registered capital. Note also that certain businesses will be required to have higher registered capital minimums. The rule is that all registered capital must be paid within two years after approval of formation of the WFOE. Fifteen percent of this amount, or the required minimum, whichever is greater, must be paid within 90 days after formation of the WFOE. The amount of registered capital must be considered carefully. Any amounts paid into the WFOE by the shareholder in excess of registered capital will be treated as income to the WFOE, and taxed as such. Accordingly, it is important not to set the registered capital number so low that you would encounter this problem. We will discuss this in more detail with you as we progress.

9. Management.

The WFOE can be managed through a) a board of directors or b) through a single managing director. For a board of directors, the number of directors is typically three. One director is selected as the representative director who has the right to enter into agreements on behalf of the WFOE. For the managing director, a single person is appointed as the managing director. This person is also the representative director. You will need to determine which management method you will use. For single shareholder WFOEs, the managing director approach is common.

You will need to designate the following directors and officers:

Directors.

If you will use a board, state how many directors. Provide the full name and address of each director.

If you will use a managing director, provide the full name and address of each director.

General manager.

The daily business of the WFOE will be managed by a general manager. This person can be a member of the board or an independent individual. The person can be a Chinese national or a foreign national. The person can be a resident of China or a non-resident. Typically, for a WFOE the general manager is a Chinese national who does not serve on the board and who is resident in China. However, there is no fixed pattern.

Supervisor.

The supervisor is responsible for supervising the conduct of the board in order to protect the rights of shareholders. In a one shareholder WFOE, the supervisor position is not necessary. However, Chinese law requires an appointment to this position. The person must be independent and cannot be a director or the general manager.

Documentation. For each person above, provide the following:

Name and address.

ID: For non-Chinese citizens, we will need four color copies of their passport. For Chinese citizens, we will need four color copies of their national ID card.

Resume: one or two page, including birth information and address, signed, four originals.

Photos: four 2″ visa size photos.

10. Proof of financial status. Normally, this can be done through a letter from your bank stating the basics of your deposit relation with the bank. We will provide you with an approved form for this letter. In some cases, the Chinese authorities will require an audit of the investor company. We will determine as soon as possible whether such an audit will be required.

I have always had trouble getting my head around the fact that to secure approval of a Wholly Foreign Owned Enterprise (WFOE or WOFE) in China, the WFOE must first lease appropriate space. But how can a yet to exist entity do anything, much less lease space?

In my email box this morning was an e-mail from co-blogger Steve Dickinson to a client in the process of forming a China WFOE that explains how. To set the scene a bit more, Steve was responding to a client who had just sent Steve a copy of its proposed lease:

This is a set of standard lease documents for leasing to a Chinese entity or to an already existing WFOE. The lease document makes no provision for dealing with the situation of leasing to an entity in preparation for formation of a WFOE. In fact, the lease document requires you to provide a business license before you execute the lease. Obviously, you cannot do that since your WFOE does not yet even exist.

You should contact the landlord and ensure that the landlord understands your exact situation. If the landlord understands and agrees that it understands and will cooperate, then we can add the language necessary for the lease to be acceptable for WFOE formation purposes. The landlord should be aware that the lease will initially be in the name of the WFOE shareholder and then will be transferred to the WFOE upon successful formation of the WFOE. The landlord must agree to that transfer in advance and must agree to cooperate fully in the WFOE formation process. In addition, the landlord must warrant that the premises can be approved for the use to which you intend to make of the premises and that the lease will be registered with the applicable government real estate administration in _______. Of course, this means that the landlord will need to make all tax payments and provide tax receipts to you as the tenant. Note that the lease cannot be entered into until you know the identity of the shareholder of the WFOE.

Please discuss this with the landlord and then advise on how you wish to proceed.

Every couple of weeks my firm gets an email or a phone call from a small business that is seeking to justify forming a Rep Office in China instead of a Wholly Foreign Owned Enterprise (WFOE). These small businesses typically go into advocacy mode explaining why their business can and should be a Rep Office in China. They then go on to explain that they simply cannot afford to form a WFOE in China due to the minimum capital requirements, the legal fees, and the taxes.

They then want me to condone their Rep Office plans but I never do.

In fact, the increasing number of these requests has caused me to get even blunter than usual, and my most recent response exemplifies this:

What you are describing doing as part of an RO [Rep Office] is definitely not proper for an RO. Not even close.

In terms of minimum capital required, because it is Dongguan, it is likely to be pretty high. Sorry.

You pretty much have two choices. You can operate completely off the grid and risk getting shut down, or you form a WFOE. Probably the worst thing you could do would be to form an RO that operates illegally because they you are just drawing attention to yourself.

I get the sense that the people contacting us on these things are hoping that they somehow have found THE loophole that nobody else has found and that if only they can get the blessings of an attorney for what they are doing, that their operating illegally will somehow not be illegal. I wish I had some magic oil I could sell (for a helluva lot of money) that I could sprinkle on illegal China businesses to make them legal, but I have no such thing.

Those who think they are going “sorta” legal by forming what is clearly an illegal Rep Office in China are very similar to those who think they are “sorta” protecting themselves legally by doing a “sorta” joint venture with their girlfriend. I wrote about those people in a post, entitled, “Operating Illegally In China. Half-Assing It Does Not Help.” In that post, I described the following email I had recently received from my co-blogger, Steve Dickinson:

We had one of these the other day and it precipitated an email from my co-blogger, Steve Dickinson, to me, which went as follows:

If these people are going to go illegal in China, they should go 100% illegal. That is, enforcement either through really strong family connections (your father knows her father) or enforcement through gangsters and the like. I know people who have succeeded this way but I don’t know anyone who has succeeded with an illegal contract. This is not because contracts don’t work in China, because you and I have won enough China contract cases to know that they do.

It is because the Chinese judges are totally on to these sorts of arrangements and they know they violate or seek to evade Chinese law. They therefore have and will continue to deem such contracts void. Why do people live in this fantasy world thinking that somehow they are so different or that they have discovered the solution? Why do they think a Chinese court would enforce a contract designed to evade the law?

Take an alternative example. Remember John Smith’s [yes, it is an alias] company we formed in Beijing a few years ago? Not sure if you remember this, but that investment was with his Chinese wife. However, we did that as a very formally organized WFOE and left the wife and her family with the irregular side of the deal. His US company is the only shareholder and he runs the board. His company has had no trouble and he has had no trouble because he is legal and secure. His US LLC [and with it, the China WFOE] were just purchased by _______ [a pretty big name U.S. company]. The reason the purchase was successful is that the whole company was “clean” and therefore it could be purchased by a foreign public company.

I then concluded that post with the following:

As lawyers we are never going to tell our client to go full illegal, but in my role as a blogger, I have to think going full illegal would probably make better sense than paying a lawyer to draft a void contract. I think people know this, but their rightful discomfort at operating illegally makes them want to clutch on to something that will allow them to justify (however falsely) their actions.

The same holds true with respect to forming a Rep Office when a WFOE is required. Forming the Rep Office in that situation will just serve to let the Chinese government know where you are and what you are doing and will make it easy for them to realize that what you are doing requires a WFOE. On top of that, as I am always saying, you should not form a Rep Office with plans to form a WFOE in a year or so “if everything works out.” You should not do this because you will end up paying THREE times as you will pay for forming the Rep Office, pay for shutting down the Rep Office (and this is not cheap), and then pay for forming the WFOE.

What really drives me crazy about all this though is that on at least three occasions, companies for whom we have refused to form Rep Offices have written me to tell me that “so and so” company formation company is willing to form the Rep Office for them, as though this mere fact means that my firm was wrong in declining to take money to do something we know will eventually not work.

And though I take no happiness from this, I will note that one of the three companies that went ahead and formed a Rep Office against our advice did contact us about a year later to tell us that the Chinese government was now making them form a WFOE.

For more on what is involved in forming a company in China, check out the following:

There are some excellent China company formation companies and there are some where you are all but guaranteed to waste your money. Some of these company formation firms (truly, always the better ones) call my firm in to assist when they are facing a new or unusual or difficult situation. Sometimes a foreign company using a company formation company will call us in to assist when they become worried about their chances for WFOE formation success. Other times, we get called in to deal with the more legalistic aspects of a formation.

I mention all this because I recently was cc’ed on an email from co-blogger Steve Dickinson to a client experiencing difficulties with forming its China WFOE using a China company formation firm. Steve’s email provides a pretty good example of the typical issues involved in forming a WFOE and, stripped of any identifiers, it reads as follows:

At this point, I will need to review the following:

Application for reservation of name;

Feasibility Report together with supporting financial statements;

Most recent proposed Articles of Association.

These three documents have to match, so review of all three at the same time is necessary.

With respect to your questions, let me know how you want to proceed. Do you want to provide me with a list of questions or do you want to schedule a conference call?

In terms of reviewing the application process, please let me know how you want me to proceed. I will need to know where you are in the process and what documents have already been prepared.

Usually I find that most clients have questions/problems with the following:

Proof of existence of the U.S. shareholder. Appropriate documents must be authenticated by both the California Secretary of State and the Chinese consulate in San Francisco.

Appropriate lease for the WFOE in China. In particular, for trading companies, the Shanghai authorities frequently insist on a warehouse space that can be quite expensive and possibly unnecessary.

Registered capital. Shanghai generally insists on at least $150,000 in registered capital. For trading companies, certain districts insist on even more. The actual amount of registered capital depends on how the total investment is explained in the feasibility report. For this reason, the actual required registered capital may be substantially higher than the local minimum.

Management structure: Board of directors or managing director. Who is the general manager and what will be its duties? Who acts as supervisor?

For trading companies, Shanghai usually imposes two additional requirements:

a. Audit of previous year’s performance for the shareholder. Closely held companies frequently do not have an appropriate audit report.

b. Listing of customs commodity codes for any product to be imported or exported.

Employment is a separate issue not directly part of the company formation process. However, your WFOE will directly employ Chinese nationals. Since this process is quite different than the indirect employment you have been using for your Rep Office, your rep office experience is not likely to be transferable to your situation as a WFOE. A major issue in the employment area is protection of intellectual property and trade secrets with respect to employees. The employment issues should be considered now, so that you are ready to proceed when the WFOE is approved.

Let me know how you want to move forward on this project. I look forward to hearing from you soon.

We have never once had a WFOE application rejected in China and though past performance is no guarantee of future success, our past performance is based in large measure on how we work with the appropriate authorities before our clients get locked into something that may lead to a rejection of their WFOE application. Sometimes we have to go to the authorities multiple times to test out “ideas” before we actually submit anything. These idea testing conversations are done without our naming the company seeking to register. Once an application has been rejected, for any reason, the chance of the company ever securing approval just went way down. What works for a trading company in Shanghai may or may not be relevant for a manufacturing company in Qingdao or a software company in Chengdu.

Around 25% of my law firm’s China legal work is done with US or European attorneys, and a good chunk of that work is helping them help their own clients form a Wholly Foreign Owned Entity (WFOE) in China. The law firms that retain us do not have their own lawyers in China but because the China work they are doing for their clients is just one part of their work for that client, quite logically, they want to coordinate that work with whichever China lawyers they retain.

We recently took on three new WFOE formation matters for US lawyers. Two of these matters are for lawyers working on behalf of their clients and one is for a lawyer who owns the (non-law related) business. All three of these lawyers told me they had spoken with company formation firms and had grown frustrated with the information they were being given. They relayed that these firms were not giving clear answers to many of their questions, but were instead responding by saying China WFOE laws were “vague” and/or “ever changing.”

What these company formation firms are saying is just not correct.

Chinese law on WFOE formations is actually quite clear and I suspect these company formation firms were claiming otherwise only because the laws are vague to them. Near as I can tell, these company formation firms typically consist of a foreign voice or two (oftentimes in Hong Kong) who takes in the work and then farms it out to a Chinese law firm in a low cost city to do the work. The people on the phone or at the other end of the e-mail at these firms have never read China’s laws on WFOE formation and so, not unexpectedly, those laws are vague to them.

As for “ever changing,” on January 1, 2006, there was a sea change in China company formation laws for foreign companies, but they have remained static since then.

By far the biggest source of confusion/frustration for these US and European attorneys seeking information on forming a China WFOE is the minimum registered capital requirement.

The law on minimum registered capital is clear, but the amount of capital that will be required does vary, depending mostly on the nature of the business of the company to be formed and on the city in which it is going to be registered.

Every company in China must have a stated registered capital. The registered capital includes all of the components of the initial investment in the company, including its start up cash, contributed property, and transferred intellectual property.

Where the registered capital is small, the entire amount must be contributed immediately upon formation of the company. If the amount is large, it may be contributed in installments. There are a number of schedules for the percentage and timing of large amounts of registered capital.

It is a crime to state a registered capital amount and then fail to contribute. It is also a crime to withdraw registered capital after it has been contributed.

The purpose of registered capital is to provide some notice to creditors of the capital adequacy of the company. Because of this, Chinese regulators take very seriously the rules regarding registered capital.

Registered capital is an initial investment that is intended to be immediately used in the operation of the company. It is not a deposit that must just sit in a bank and never be touched. It can be used to pay salaries and rent, to purchase product, or for any other normal start up operating expense. Registered capital may include contributed real and personal property used in operating the business. Many foreign investors think registered capital is some sort of security deposit that they can never utilize. This is not true.

On the other hand, some foreign enterprises believe they can simply withdraw their registered capital to their home country after the Chinese company begins normal business operations. This also is not true. The only way to get funds from the Chinese company out of China is by repatriating profits or by liquidating the Chinese company. Both of these methods will work, but they both require paying Chinese taxes and meeting other requirements under Chinese law.

Investors should also note that the RMB is not a freely convertible currency. For companies that will earn RMB income, the issue of conversion to U.S. dollars or other foreign currency should be carefully considered.

Chinese law is quite clear regarding minimum capital requirements for a WFOE but the statute’s prescriptions on this are essentially meaningless in actual practice. Under Chinese Company Law, the minimum capital requirement is either 30,000 RMB (less than $4,000 US) or 100,000 RMB (a bit over $12,000 US) depending on whether it is a multiple or single shareholder company. However, these numbers have no real meaning for forming a WFOE in China.

The real question is what the Chinese authorities will consider as adequate capitalization for the specific project and that always depends on the type of business and its location. For example, it is very expensive to operate a business in Shanghai. On the other hand, it can be very inexpensive to operate the same business in a rural part of China. It is expensive to operate a capital intensive business like manufacturing, but relatively inexpensive to operate a knowledge based consulting business. Finally, some Chinese cities just seem to want WFOEs more than others.

The Chinese regulators usually consider all of these issues. To complicate matters, each local regulator has its own basic standards on what constitutes adequate capital for certain types of business activities. These numbers are not published, but when asked they will almost always be provided. They can only be determined through direct contact with the regulator but only after providing a clear explanation of the project.

The local regulator virtually never considers the statutory minimum in making a determination regarding adequacy of capital. Rather, the local regulator will determine what it believes is an adequate amount of capital based on all the circumstances. Once the investor has a clear idea of the outlines of a project, it is usually a good idea to engage a China attorney to contact the local regulator to see what their response will be to the proposed amount of investment. This initial screening can save a lot of time if the investor’s idea of the proper amount of capitalization is dramatically different from that of the local regulator.

My firm’s China attorneys always go to the local regulators to get this amount before we get very far along in the application process. Almost without exception, our experience has been that after we explain the nature of our client’s business to the regulator, the regulator’s decision on the minimum capital required has been a very workable one for our clients.

In determining what constitutes adequate capital, one needs to consider the peculiar situation in China that all rents are paid in advance, that payment for products for sale are usually paid in advance, and that a reasonable advance reserve for salaries is also required. Thus, the initial start up cost is going to be higher than for a comparable company in the United States, where credit and time payments are much more common. Chinese regulators will not approve a project that looks risky or under-funded.

China’s recently stepped up effort to root out foreign companies doing business in China without being registered to do so has caused a rash of China consultants to retain the China lawyers in my firm.

From our work in forming China WFOEs for these consultants, we have learned that many China consultants are falling dangerously short in various other legal aspects of their business as well. Indeed, if we were to single out the foreign businesses in China most often guilty of underestimating their legal risks, it would be China consultants. China consultants seem to have been in China so long that they have lost sight of the fact that when push comes to shove (or as we lawyers like to say, when a deep and easy pocket needs to be found) they are the American/European/Australian company that is going to need to answer for what happened. These China hands also fail to recognize how much China has changed in the last decade and that doing business in China today is just not the same as it was five years ago. Not even close. If you are a Western consultant hired by a Western company to assist in China, you must realize that if something goes wrong for your client you will be your client’s first choice for legal redress.

What can go wrong? And what can you as a China Consultant do to prevent or ameliorate it? Overall corporate planning to protect your personal assets is an absolutely necessary first step. Beyond that however, and more specifically to China, you can do a lot to protect your client and thereby protect yourself.

We have seen the biggest problems with sourcing consultants that assist in finding Chinese manufacturers. A typical sourcing project, might go like this:

Western company retains a product sourcing consultant to find the best Chinese widget manufacturer in terms of cost/quality/dependability.

Consultant requests and secures sample widget from manufacturer.

Consultant meets with countless Chinese manufacturers in search of the best one.

Consultant recommends company Z in China to manufacture 100 million widgets.

Consultant is to be paid a percentage of the manufacturing costs.

Company Z starts manufacturing the widgets.

By this point, I am guessing the sourcing consultants reading this are saying, “yes,” while the China attorneys out there are already apoplectic. Let’s deconstruct this hypothetical project and note where the consultant has potentially harmed the client and needlessly taken on huge liabilities for itself.

The sourcing consultant agreed to find “the best” widget manufacturer. Is that best in China or best in the world? What if the widget manufacturer charges one hundred dollars a widget for the 100 million widgets, but your client’s competitor finds another widget manufacturer who will do it for ninety dollars. Are you liable for the difference? Even worse, what if your client’s competitor gets the same Chinese widget manufacturer to do 100 million widgets for ten dollars less? Do you really think a US jury is going to believe you were doing your best when your fee was a percentage of the final costs? Are you responsible for the Chinese manufacturer’s late deliveries? For the Chinese manufacturer’s bad product? Is it clear exactly what your percentage is going to be based and have you set things up so that your client cannot just go around you? The Solution: Use a well-crafted written contract to make clear exactly what you will and will not do. Put in a non-circumvention provision to make sure you get paid.

If you take a sample to China and start showing it to potential manufacturers without FIRST putting in place various safeguards, you are courting disaster. The sample could be used for counterfeiting. We had a consultant call one of our China lawyers in a panic after returning from China to learn that one of the manufacturers to which he had shown a sample had already started manufacturing the product for someone else using the consultant client’s trademark which it had gleaned from the Internet. The Solution: Never show a sample or product plan or reveal your trade name(s) without first making the Chinese manufacturer sign a China-centric NNN Agreement (essentially a hopped up NDA that protects against competition, circumvention and disclosure). Chinese manufacturers tend to be quite familiar with NNN agreements and if you give them a simple and reasonable one, in Chinese, they will sign it.

You the consultant must do more than simply negotiate the price and delivery dates or you should at least make clear in writing that these are your only tasks. Typically, product sourcing consultants oversee the OEM contract with the manufacturer and by doing so, they face major liability issues if that contract is not up to snuff. You are the “China guy” and your client is counting on you to guide it through China’s business minefields. You are the one who is supposed to know anything and everything about what it takes to do business in China. Equally importantly, with the manufacturing of its product, your client is probably turning over to the manufacturer all sorts of critical intellectual property. Your client probably thinks that its existing patents, trademarks and copyrights will protect it in China, but a court will expect you as the China expert to know better. The Solution: Put in writing with your client that you will not be providing it with legal advice and that it will need to retain its own lawyer to draft the OEM agreement with the Chinese manufacturer. Put in writing that it is your client’s responsibility to protect its intellectual property in China and that to do so, it must register its IP in China, either through a lawyer with whom you connect them or independently).

Just remember that your client sees you as the expert at doing business in China and it is looking to you for help in all areas and if you fall short in any way, you are at risk for a lawsuit.

The Tri-Valley (California) Herald recently ran a nice story [link no longer exists] on the Dahlin Group, a small, local, architecture firm that has had considerable success in China. I love this story because it puts facts to the following four things we are always saying:

China is booming. Go there for growth.

China’s service sectors are particularly hot.

Small businesses, particularly service businesses, can thrive in China.

WFOE is the way in China.

If you are a small service business thinking of expanding to China, I suggest you read this article. Though I am certainly not saying that the Dahlin Group’s China entry path is the only way to do things, I am impressed with this company’s vision and its measured approach to China entry and business.

About China Law Blog

We will be discussing the practical aspects of Chinese law and how it impacts business there. We will be telling you what works and what does not and what you as a businessperson can do to use the law to your advantage. Our aim is to assist businesses already in China or planning to go into China, not to break new ground in legal theory or policy.